Earnings Call Transcript - JCI Q3 2021

Operator, Operator

Welcome to the Johnson Controls' Third Quarter 2021 Earnings Call. Your lines have been placed on a listen-only, until the question-and-answer session. This conference is being recorded. If you have any objections, please disconnect at this time. I'm now going to turn over the call to Antonella Franzen, Vice President, and Chief Investor Relations and Communications Officer.

Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer

Good morning and thank you for joining our conference call to discuss Johnson Controls' third quarter of fiscal 2021 results. The press release and all related tables issued earlier this morning as well as the conference call slide presentations can be found on the Investor Relations portion of our website at johnsoncontrols.com.

George Oliver, CEO

Thanks, Antonella, and good morning everyone. Thank you for joining us on the call today. Let me kick things off with a brief update, spotlighting a few specific areas related to our strategic initiatives. Olivier will provide a detailed review of Q3 results and update you on our forward outlook. We will leave as much time as possible to take your questions. Let's get started on slide three. Another quarter of solid results, with demand accelerating across most of our end markets as a robust recovery continues to expand. Q3 represents our easiest comparison of the year, but I am encouraged to see the underlying sequential improvement experienced in the first half continue to accelerate in the third quarter, with many of our businesses back to operating at pre-pandemic volume levels. Non-residential construction markets continue to recover led by the ongoing strength in retrofit activity, tied to demand for healthy building solutions. New construction is also beginning to show signs of stabilization, and the inflection in order trends for our longer-cycle project businesses sets us up well as we look to next year and beyond. Our service business has recovered, and we continue to transform this business through our digital service strategy to drive higher levels of recurring revenue and an improved growth profile. This recovery has not been without its challenges. We have managed through significant headwinds related to persistent supply chain disruptions, component shortages, labor constraints, and continued inflation. While these dynamics have created some revenue pressure which will continue in the near term, the pace and composition of order growth in the quarter provides confidence that we will remain on track over the medium and long-term.

Olivier Leonetti, CFO

Thanks, George, and good morning, everyone. Continuing on slide eight, organic sales accelerated in Q3 by 15%, aligning with the guidance we provided last quarter as growth in global products and our field businesses accelerated. The strength in global products was across the board from continued high levels of demand in residential end markets, including both our Global HVAC equipment and security products due to the anticipated rebound in commercial HVAC and fire and security. Segment EBITA increased 21% versus the prior year, and segment EBITA margin expanded by 30 basis points to 16.2%. Better leverage on higher volumes, the benefit of our SG&A actions, and strong execution more than offset the significant headwind from the reversal of temporary cost reductions and a modest headwind from negative price costs. EPS of $0.83 increased 24%, benefiting from higher profitability as well as a lower share count. On cash, we had another strong quarter, with free cash flow in the quarter at $735 million, flat versus the prior year despite the planned uptick in CapEx. I'll give you further details of our performance later in the call.

Operator, Operator

Thank you. We will now begin the question-and-answer session. Our first question comes from Joe Ritchie of Goldman Sachs. Your line is open.

Joe Ritchie, Analyst

Thanks. Good morning, everybody.

George Oliver, CEO

Morning, Joe.

Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer

Morning, Joe.

Joe Ritchie, Analyst

So, maybe just starting off, I just wanted to talk about the cost pressures, and talk about inflation and how that impacted the business this quarter. I was also thinking about what's embedded for the temporary cost actions as we head into Q4. How much does that step down from Q3 into Q4, clearly recognizing that there was a pretty big headwind this year from the furloughs reversal?

George Oliver, CEO

Yes, Joe, let me take that and then I'll turn it over to Olivier to give you some additional color on a year-on-year basis. When you look at the year, the way that we set up the year and made sure that we were anticipating the inflationary pressures and ultimately making sure that we're driving the proper level of price, as well as continuing to drive productivity, we've built that into our model. And so every step through the year we've been staying ahead on pricing, and we've been ultimately driving additional productivity to offset some of these headwinds. From a pricing standpoint, over the last couple of years we've built a lot of strong strategic capability across our businesses. That has played out extremely well during this period of time. With the inflationary environment, we knew that was going to be a challenge in the second half, and we anticipated that. We probably have about two points of price flowing through the top line, which given the timing of that, has created some headwind here in the third quarter. But with the work that we've done, we're going to be set up to continue to deliver on the 80 or 90 basis points of margin expansion for the year. I think the team has done an incredible job from where we first set the year up, and how we've executed; we've executed extremely well. Olivier?

Olivier Leonetti, CFO

No, absolutely. Good morning, Joe. At a high level, we mentioned this. So, 30 basis points of EBITA margin increase in the quarter. We had the impact of Silent-Aire for about 10, so it's a 40 basis point increase in Q3. Going through some of the elements you asked specifically about productivity. The impact of our temporary actions from last year, net of our ongoing productivity program is about 160 basis points in the quarter. If you look at price costs, the impact in Q3 is around 40 basis points. We believe we will be price cost positive for the second half. So, of course, Q4 would be positive. Regarding the headwind from temporary actions in OpEx net of our ongoing productivity actions, the impact would be about 50 basis points negative in Q4. So we are positioning for improvement in margin rates despite two major headwinds which are temporary in nature. We feel good about our ability to continue improving the profitability of Johnson Controls.

Joe Ritchie, Analyst

That's very helpful and clear, thank you. And then maybe just my follow-on question. I know that you probably don't want to preview too much about what we'll hear on September 8. But if you could give us any kind of color on how you're planning to organize the virtual Investor Day and the key topics that you'll be focused on?

George Oliver, CEO

Yes, Joe. We're setting that up very much in line with the strategy that we've communicated with all of our key growth vectors and how we're not only reinvesting in products and technology, OpenBlue, but also making sure that we're positioned to capitalize on big growth vectors as we build out our digital services, as we capitalize on the trends in decarbonization, and as we capitalize on the significant market being developed with healthy buildings. We want to ensure that is coming together to support the core because at the end of the day we have a unique position here with the combined portfolio to truly lead the future buildings as we think about healthy buildings—not only healthy people, healthy places, healthy planet. That will be core to our strategy. Supporting all of that will be the strategic priorities that we are executing on operationally that ultimately deliver on acceleration of growth and above market growth while we're continuing to deliver best-in-class margins and being able to close the gap that we've had through our programs. We're extremely excited about the progress we've made, and really looking forward to laying that out in detail on September 8.

Joe Ritchie, Analyst

Great, thank you. Look forward to it.

Operator, Operator

Thank you. Our next question comes from Josh Pokrzywinski of Morgan Stanley. Your line is open.

Josh Pokrzywinski, Analyst

Hi, good morning, guys.

Antonella Franzen, Vice President, Chief Investor Relations and Communications Officer

Good morning, Josh.

Olivier Leonetti, CFO

Morning.

Josh Pokrzywinski, Analyst

Olivier, thanks for all the color on some of the margin drivers in Q4. I know price cost is always a bit of a moving target, and it seems like you're getting on top of that. So, I guess it leaves net productivity as maybe the biggest factor for getting all those actions to drop to the bottom line and the overall EBITA leverage. But when does that 50 basis points of net headwind split more acutely, either based on the comparison for the temporary items or just the productivity deck ramping up?

Olivier Leonetti, CFO

Thank you for your question. The main impact of the headwinds is in Q3, by a wide margin. That's true, by the way, for the full fiscal year. Our ongoing productivity actions have equal weight in Q3 and Q4.

Josh Pokrzywinski, Analyst

Got it. And then, George, a question for you just on kind of the overall cadence of demand or mix of drivers here. I think across the building space, there is this heavy cocktail with cyclical recovery and some of the secular drivers that you talk about, whether it's IQ or building efficiency infrastructure. It does seem like there's some order momentum. But when do we see these tailwinds stack up where you get the cyclical and secular at the same point? Do you think that those can actually overlap or the secular stuff may take a little bit longer?

George Oliver, CEO

Hey, Josh, let me say that in all the time that I've been in these businesses, I've never seen as fast of a recovery to get back to where we were as I've seen with this cycle. If you look at why that's true with our business, the general macro conditions continue to improve, although they're not linear across all the regions, as Olivier laid out. We're seeing continued momentum in construction-related indicators, and that's beginning to accelerate. We're actually seeing that come through, supported by ABI continuing to be very strong. Dodge construction starts are improving sequentially. We're very active in earlier shorter-cycle projects, which are really outperforming right now. A lot of that demand is focused on healthy buildings—this has been critical in how we filled in our backlog through the year. Retrofit, especially these smaller term projects, continue to ramp up. In North America, they were up year-on-year or over 30%. That has been a big driver of our install business. When Olivier talked about our backlog, we have a record backlog, we're up 7%, and as we play out Q4, we don't see any slowdown. As we begin to set up for '22, that pressure we've had in '21 has come back nicely.

Olivier Leonetti, CFO

Let me give you, Josh, some additional statistics. We gave some of those in our prepared remarks. The decarbonization market is a market we believe will be around $250 billion over the next 10 years. If you look at our performance infrastructure contract, this business is year-to-date growing at about 15%. Last year, this business was growing 2%, so it’s really accelerated. Regarding indoor air quality, if you look at retrofit, the older growth was in the quarter near 30%. We see this retrofit increasing and new builds are inflecting positively; install is up 16%. Our services are performing well, and we're seeing clear indicators that we’re getting traction.

Josh Pokrzywinski, Analyst

Thank you both for all the color. Really appreciate it.

Operator, Operator

Thank you. Our next question comes from Nigel Coe of Wolfe Research. Your line is open.

Nigel Coe, Analyst

Thanks. Good morning. Better saying about the virtual thing for September 8. I was actually looking forward to coming to Milwaukee. So that's understandable, I guess.

Olivier Leonetti, CFO

We were also looking forward to it, Nigel.

Nigel Coe, Analyst

Then the Delta variants. This one is just to kind of inquire about the APAC margins because it seems to me I understand the temporary cost comments, but it does feel like there’s a bit of a mix issue as well. I'm just wondering, is that China growth primarily, you did call out country mix there and thinking about the price costs, Olivier you mentioned price costs were the toughest quarter from perspective. Did that hit more in APAC than other regions?

Olivier Leonetti, CFO

You’re right, Nigel. Two impacts for APAC. One, country mix, particularly in China, and number two, the actions we took last year to reduce our OpEx base. It's difficult to read the quarter because of those phenomena; we have data impacting APAC and also North America. Structurally, the margin profile of the business is improving across the portfolio, including the regions, net of those one-offs.

George Oliver, CEO

Nigel, there is a bit of mix there across the region where we've had continued pressure with volumes that is beginning to come back as we see our Japan business and the business we have in Hong Kong, so there’s some mix there.

Nigel Coe, Analyst

Okay. Thanks, George. And then, on OpenBlue, the patent filings are very encouraging? How do we measure OpenBlue success momentum from an external perspective? Is it really just the cadence on installations and services, are there other metrics that you can call out to give us a sense of how we're progressing here?

George Oliver, CEO

Yes, let me frame it up for you, Nigel. OpenBlue is now being incorporated; we're leveraging OpenBlue with all of our services, connecting all our installations, extracting all the critical data, and then applying AI and analytics to that data to create new outcomes. Not only are we doing this with the core business, but we’re building out new capabilities across all of our digital platforms, bringing them together into one architecture. When you look at our digital revenues today, we're up strong double-digit growth across all of our platforms and through our digital services. We build our pipeline across all three regions; we have much more significant digital content being built into the solutions we're deploying, showing that we're differentiating the value we bring to our customers with new offerings. That pipeline is well over $1 billion going forward. Those are the ways you can look at how it's being deployed, and the impact it's having—not only on decarbonization. But now as we look to really lead what I would call autonomous buildings of the future. We’re positioning ourselves to achieve these major outcomes, and there’s going to be incremental revenue from these advancements.

Nigel Coe, Analyst

Thanks, George. I'll leave it there.

Operator, Operator

Thank you. Our next question comes from Jeff Sprague of Vertical Research. Your line is open.

Jeff Sprague, Analyst

Hey, thanks. Good morning, everyone. Just two from me. Could we drill in a little bit on what's going on in your residential and light commercial business and maybe some production or supply chain disruptions there? You characterized residential as kind of in line with your expectations, but the market looked like it was stronger than that in the quarter. So, give us a little bit of color on what's going on in that business. And do you have the ability to maybe uncork some more volume at your facilities there?

George Oliver, CEO

Jeff, our light commercial includes not only the light commercial unitary rooftops but also VRFs, and we've been launching new products. We’ve got a product lineup of three new product launches, and we’ve been expanding capacity with those launches. Now with this strong recovery, we’ve been working to keep pace with market recovery. Our orders, when looking at that space, were up about 75%, so we didn’t get the push through here during the quarter, but we’re continuing strong with the new products and have a backlog that is now up three times from what it was a year ago. It’s a lot about the cycle time of conversion, and we’re continuing to expand capacity for the new products that we’ve launched.

Jeff Sprague, Analyst

Understood. And maybe you could give us a little update on Silent-Aire now that you own it. Obviously, you haven't owned it for long, but kind of initial customer response, how you plan to pull the business around the globe? Any change in customer behavior or anything like that since you took the keys to the asset?

George Oliver, CEO

Yes, Jeff. I mean, I couldn't be more excited. As things have opened up, I’ve had the opportunity to visit our Silent-Aire team and a couple of sites out in Phoenix recently. I couldn't be more excited about how this fits into our priorities. This is bolt-on technology that fills out white space we didn't have capability in. It also enables us to build out and increase install base where there hasn't been significant service, with tremendous opportunity to build service on top of those offerings. The whole digital content—being able to take what they do so well working with datacenter operators that really are innovative—configures the technology differentiates how they work with each of these datacenter operators. Combining that with digital truly becomes a game-changer. I believe, as we look at datacenters and how we’re going to leverage this capability alongside our core capabilities, I couldn't be more positive. Any integration will require a lot of work, but having engaged with the team and taken a pulse on where we are, that's going to play out really nicely for us.

Olivier Leonetti, CFO

One additional color on your first question on residential: In North America we have been at capacity from a manufacturing standpoint for a few months, few quarters. We are adding capacity at the start of our fiscal year very soon, and we believe we’ll be able to change that trajectory. We are adding a considerable amount of capacity, actually.

Jeff Sprague, Analyst

Great. Thank you for that color.

Operator, Operator

Thank you. Our next question comes from Deane Dray of RBC Capital Markets. Your line is open.

Deane Dray, Analyst

Thank you. Good morning, everyone.

George Oliver, CEO

Good morning, Deane.

Deane Dray, Analyst

I want to start off with a question directed to Olivier. The performance on trade working capital is impressive in a quarter when many of your peers are needing to add buffer inventory. We see the trading capital moving against you. I did see inventory was up $7 million, but could you talk us through where it stands overall, just trade working capital and how you're navigating through this period?

Olivier Leonetti, CFO

Deane, thank you for your question. So, a remarkable performance in trade working capital, 11% of revenue in the quarter, down from about 13.5% in the same quarter a year ago. All the levers are in our favor. Let me speak now in terms of days. DSO is down nine days year-on-year, which is structural, and we have strong mechanics in place to manage DSO effectively. If you look at DPO improvement year-on-year by about four days, again structural; we have various programs in place to make our DPO even better for Johnson Controls. Last on inventory, we've done a good job, which is a byproduct of strong demand. Some inventory improvements—15 days in total—are structural, and some are temporary, but we feel good about the free cash flow generation of the company. We stated before, Deane, that we were a 100% free cash flow organization, which would be at 105% including restructuring. The run rate is closer to 115%, and we feel strong about free cash flow generation in our company.

Deane Dray, Analyst

Well, that's all great to hear; it's such a difference compared to where the company was a couple of years ago on working capital management. Being comfortably above 100% is a significant congratulations to the team there. Second question for George: Just put this net zero building as a service that you're highlighting today in context. It’s encouraging to see a SaaS business being added to this, but where does it stand in the priority stack in terms of indoor air quality? Are there any regulatory oversight coming into the industry on how these calculations are being made because obviously this feeds into each of your customers' ESG rankings and so forth?

George Oliver, CEO

So, Deane, let me start with healthy buildings and indoor air quality, which is front and center given the significant demand. We-sized that market to be $10 billion to $15 billion at a double-digit CAGR. We have secured over $300 million to date and have a pipeline well over $1 billion. This acceleration is due to reopening and return plans. A key space for us within healthy buildings is K-12; we’re across 6,000 school districts in the U.S., as well as 1,900 higher-ed institutes. It’s our ability not only to do pure equipment upgrades but to take our combined capabilities within a building to create the best outcomes for healthy buildings and overall air quality. As we think about decarbonization and sustainability, we’ve been in that space for years with our performance contracting business, reducing energy consumption and carbon footprints. The recent commitments to net zero emissions have enhanced our offerings to provide a full solution to a building, optimizing equipment and how it operates with occupants while targeting energy and decarbonization goals. We believe this can lead to a $240 billion market, building on the $300 billion+ market we already serve. Our advanced products, building systems, and the integration of OpenBlue and digital capabilities will create the best outcomes for efficiency and supply through renewables. This will unfold longer-term but it’s an attractive space for us.

Deane Dray, Analyst

Terrific. I'm sure we'll hear more on that on September 8 too. Thanks.

Operator, Operator

Thank you. Our last question comes from Steve Tusa of JPMorgan. Your line is open.

Steve Tusa, Analyst

Hi, good morning.

George Oliver, CEO

Good morning, Steve.

Steve Tusa, Analyst

On the services revenue growth of 11%, what do you expect going forward? There’s a confluence of events with easier comps, but also some momentum. How do we think about that growth rate over the next 18 to 24 months?

George Oliver, CEO

Yes, we've made incredible progress in taking our $6 billion business and fundamentally differentiating it. We believe that when we deploy our digital capability with our core competency and connect everything, that in itself will uplift revenue. We're up to 400 basis points of improvement on attach rates, and everything that we deploy now attaches to contracts. Additionally, we're differentiating services we perform with data from the systems we deploy to optimize operations. With increased installed bases, this attach, and new opportunities in healthy buildings and decarbonization, we believe we can deliver 200 to 300 basis points of growth above the market, and as these trends accelerate, there is potential for exceeding that further. Our focus on connection, additional services, utilizing data, customer retention, and creating outcomes not previously achieved will be critical.

Steve Tusa, Analyst

Got it. On your commercial orders being up significantly, what were the applied orders up in the quarter for your applied equipment?

George Oliver, CEO

Yes, when you look at our commercial HVAC business, I’m extremely pleased with performance. It’s a combination of new products that we continue to launch, and we’re gaining share across the board while embedding technology within the products to easily connect them for long-term service. Orders were greater than 20% globally. For the quarter, applied equipment, as part of the overall 21% increase, was up over 50%. We feel really good about the backlog we’ve built and how that will play out, with continued growth across all three regions; it is a strength for us.

Steve Tusa, Analyst

Thanks a lot.

Operator, Operator

Thank you. Our next question comes from Scott Davis of Melius Research. Your line is open.

Scott Davis, Analyst

Hey, good morning, guys.

George Oliver, CEO

Good morning, Scott.

Scott Davis, Analyst

When you talk about being on the right side of pricing versus cost in Q4, is that primarily material, labor, and logistics, or just the material side?

George Oliver, CEO

It's mainly material, which is the big headwind we’re looking at. Copper and aluminum prices are declining. Steel is still up, but steel mills are starting to catch up; lead times have been reduced by 75%. Analysts are predicting that the price of steel should drop significantly by December, so we believe the worst is behind us in commodity pricing.

Scott Davis, Analyst

I know your fire and security business is more labor-intensive than HVAC. Are there labor shortages that concern you? Do you feel that you can handle rising orders here?

Olivier Leonetti, CFO

Yes, Scott, we anticipated challenges as the recovery heated up. We’ve implemented PMOS to focus on labor and ensure we're recruiting effectively. While we've ramped up significantly, we have faced some pressures, but I feel very good about our progress in supporting recovery and the growth we’re projecting.

George Oliver, CEO

Stating the obvious, our guidance includes consideration of the current environment.

Scott Davis, Analyst

Understood. Thank you. Good luck, guys.

Olivier Leonetti, CFO

Thank you.

George Oliver, CEO

Thanks, Scott.

Operator, Operator

Thank you. Our last question will come from Julian Mitchell of Barclays. Your line is open.

Julian Mitchell, Analyst

Hi, good morning. I wanted to follow-up on the margin point. Olivier, you mentioned a 40% baseline increment in the medium term, leaving aside portfolio changes. I want to confirm your confidence in that amidst the current cost environment. Do we expect broadly similar trends to hold for Q4 by segment as we saw in Q3?

Olivier Leonetti, CFO

Julian, thank you for your question. We're confident about our productivity goals; our programs are on track, and we’re slightly ahead on SG&A. COGS will have an impact next fiscal year, but we are pleased with our current standing. We still hold to the $550 million of net profit drop to the bottom line. We remain bullish about our ability to achieve 40% incremental growth over the next two years, despite labor and commodity trends.

Julian Mitchell, Analyst

Thanks very much. Thinking about your fire and security field business, JCI's approach is broad, incorporating services with products. We’ve seen peers take different approaches, such as demerging an F&S field business from products. Can you help us understand how substantial those revenue synergies are from having a strong F&S field business supporting product sales, and helping build service activity?

George Oliver, CEO

Let’s look at fire and security in the quarter. Although it lagged somewhat, recovery has come back strong—not only in our products, which are up over 30%, but now converting with new installs and building backlog. The installed base spins out attractive service revenue. Our fire and security field business brings in about $7 billion in revenue and is one of our highest margin views. Fire and security products yield another roughly $2 billion, allowing for robust service growth opportunity with this base. Our strategic integration and ability to capitalize on decarbonization, healthy buildings, and leveraging systems within a building will provide a competitive advantage. Overall, we expect more incremental growth as these trends accelerate.

Julian Mitchell, Analyst

Great, thank you.

George Oliver, CEO

Operator, we will close up the call. I want to thank everyone for joining our call this morning. We’ve had a very strong third quarter, and the momentum we're seeing across our portfolio in key verticals, coupled with our strategic focus and improved execution, gives me high confidence in our ability to keep outperforming. As we move forward, we look forward to speaking to many of you and hope to see you virtually at our Investor Day coming up on September 8. So, on that, Operator, that concludes our call.

Operator, Operator

Thank you for your participation in today's conference. You may now disconnect at this time. Have a wonderful day.